On May 14, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation1 with the Republic of Croatia.

Croatia remains stuck in an unusually drawn out recession. In 2013, real GDP contracted for the 5th consecutive year, and stands now at less than 90 percent of the end-2008 level. Unemployment has risen to 17 percent. Domestic demand remains depressed as corporations and households focus on reducing excessive debts accumulated in the 2000s. Exports and Foreign Direct Investment (FDI) are also feeble, reflecting deep-seated structural weaknesses and poor trading partner growth. Macro-policies that could revive growth rapidly are beyond reach: fiscal policy has run out of space, while monetary policy is constrained by the need to keep the kuna-euro exchange rate stable, lest a depreciation cause a revaluation of euro-indexed debts.

The recession is putting pressure on the public finances. In 2013 the deficit (cash basis) widened to around 5½ percent of GDP, owing to weak revenues and the assumption of debts and arrears from state-owned enterprises. Public debt now exceeds 60 percent of GDP and is increasing rapidly. Reflecting these developments, all major rating agencies have downgraded Croatia to sub-investment grade. From this year, fiscal policy is subject to the European Union’s Excessive Deficit Procedure.

The government has started tackling long-standing structural issues, such as restructuring and/or privatization of state-owned enterprises, passage of laws that facilitate investments, the introduction of an out-of-court settlement procedure for insolvent corporations, the reduction of work force restructuring costs, and the easing of hiring restrictions.

The outlook is for another contraction in 2014 of almost 1 percent. Real domestic demand would remain feeble, reflecting both weak private sector demand and fiscal consolidation, while exports would benefit somewhat from the projected pick up in the euro area. Inflation would remain low. In 2015 a tepid recovery would set in, as the impact of private sector deleveraging would begin to recede and external demand strengthens further. Long-term potential growth is projected at around 2 percent.

With traditional fiscal and monetary policy responses out of reach, private sector debt restructuring and measures to attract FDI provide the best prospect to revive growth in the short- to medium term. Credible and sustained fiscal consolidation is needed to strengthen confidence in macro-economic management. Given the protracted economic weakness, it is adequate to stretch fiscal adjustment and start with steps least harmful to demand. The central bank has maintained confidence in exchange rate stability through a limited but effective set of instruments, but should continue accumulating foreign exchange reserves until coverage is fully in line with standard adequacy metrics.

Executive Directors noted that the Croatian economy remains in recession, unemployment is widespread, the fiscal position has worsened, and downside risks weigh on the near-term outlook. With countercyclical responses limited by the exchange rate regime and lack of fiscal space, Directors encouraged the authorities to rebuild fiscal buffers and to undertake deeper institutional and structural reforms to revive growth and reduce vulnerabilities, including by accelerating private sector debt restructuring.

Directors agreed that sustained fiscal consolidation is needed to secure debt sustainability. Noting the front-loaded adjustment in the context of the European Commission’s Excessive Deficit Procedure, they stressed that fiscal policy for the period ahead needs to manage a difficult tradeoff between the speed of consolidation and its drag on economic activity. More broadly, Directors advised the authorities to develop comprehensive plans to frame fiscal adjustment over the medium term, in order to reduce policy uncertainty and maximize the impact of consolidation on confidence. Such a plan should give consideration to both revenues and expenditures measures, including a modern property tax and an overhaul of the public finances at lower levels of government.

Directors generally supported the authorities’ plans to use monetary policy to safeguard their exchange rate objectives and to maintain adequate reserves. They also took note of the staff’s assessment that the real effective exchange rate may be modestly overvalued but underscored the uncertainty surrounding such assessment.

Directors commended the central bank for its bank capitalization policy, which has bolstered the stability of the financial system by ensuring that banks possess ample loss-absorbing capacity. Nonetheless, Directors encouraged the authorities to remain vigilant against risks to both banks and the sovereign from loans to state-owned enterprises.

Directors welcomed the progress made in structural reforms but highlighted that further efforts are necessary to enhance external competitiveness and facilitate balance-sheet repair in the private sector. They underscored the need for reforms to raise labor force participation, address labor market rigidities, restructure state-owned enterprises, and improve the business and investment climate, particularly through judicial reform. The labor legislation currently under parliamentary consideration could strengthen the labor market’s capacity to adapt to shocks. Continued efforts should also be made to ensure the rapid and efficient absorption of EU funds.

Croatia: Selected Economic Indicators, 2007–15 1/

2007

2008

2009

2010

2011

2012

2013

2014

2015

Est.

Proj.

Proj.

Output, unemployment, and prices

(Percent change, unless otherwise indicated)

Real GDP

5.1

2.1

-6.9

-2.3

-0.2

-1.9

-1.0

-0.8

0.5

Contributions:

Domestic demand

6.6

3.4

-11.2

-5.3

0.0

-3.3

-1.1

-1.3

0.2

Net exports

-1.5

-1.3

4.2

3.1

-0.2

1.5

0.1

0.5

0.3

Unemployment (ILO, percent)

9.4

8.3

9.0

12.1

13.6

16.1

16.6

16.8

17.1

CPI inflation (average)

2.9

6.1

2.4

1.0

2.3

3.4

2.2

0.5

1.1

Average monthly nominal wages

6.2

7.1

2.2

-0.4

1.5

1.0

0.8

…

...

Saving and investment

(Percent of GDP)

Domestic investment

31.4

33.4

27.6

23.6

22.8

21.9

21.3

20.1

20.3

Of which: fixed capital formation

26.2

27.4

24.5

20.8

19.6

18.6

18.4

18.3

18.7

Domestic saving

24.2

24.5

22.4

22.4

21.9

21.8

22.6

21.7

21.3

Government

3.9

3.2

0.2

-1.5

-1.9

-0.8

-2.6

-1.0

0.2

Nongovernment

20.3

21.3

22.3

23.9

23.8

22.7

25.2

22.7

21.1

Government sector 2/

General government revenue

39.8

39.2

39.0

38.2

37.4

38.4

37.9

40.3

40.7

General government expenditure

40.8

40.1

42.2

42.7

42.0

41.7

43.4

44.2

44.4

Unspecified measures (EDP)

...

...

...

...

...

...

...

…

0.8

General government balance

-1.0

-0.9

-3.3

-4.5

-4.6

-3.3

-5.4

-4.0

-2.9

General government balance (broad definition) 3/

-3.1

-2.3

-5.5

-5.4

-5.2

-4.2

-5.9

-4.5

-3.3

Cyclically adjusted balance

-2.3

-2.6

-2.3

-3.4

-3.9

-2.1

-4.5

-3.0

-2.0

Structural balance (IMF calculation)

-2.3

-2.6

-2.3

-3.4

-3.9

-2.1

-4.5

-3.4

-2.6

General government debt

32.9

29.3

35.8

42.6

47.4

54.0

60.0

64.7

66.8

Money and credit 4/

(End of period; change in percent)

Bank credit to the nongovernment sector

15.4

13.3

0.4

4.4

4.6

-5.4

-2.2

-2.1

...

Broad money

18.5

4.7

0.1

3.0

1.6

3.2

2.9

3.8

...

Interest rates 5/ 7/

(Period average; percent)

Average kuna deposit rate (unindexed)

2.3

2.8

3.2

1.8

1.7

1.9

1.5

1.4

...

Average kuna credit rate (unindexed)

9.3

10.1

11.6

10.4

9.7

9.5

9.2

8.6

...

Average credit rate, foreign currency-indexed loans

6.3

7.5

8.1

8.1

7.3

7.0

6.8

6.9

...

Balance of payments

(Millions of euros, unless otherwise indicated)

Current account balance

-3,151

-4,255

-2,408

-582

-389

-40

564

695

444

Percent of GDP

-7.3

-9.0

-5.1

-1.1

-0.9

-0.1

1.3

1.6

1.0

Capital and financial account

5,192

5,399

4,418

1,804

1,882

397

2,268

363

634

FDI, net (percent of GDP)

8.0

6.9

3.3

1.3

2.4

2.5

1.3

1.8

2.1

Overall balance

722

-330

896

84

401

46

1,844

71

90

Debt and reserves

(End of period; millions of euros, unless otherwise indicated)

Gross official reserves

9,307

9,121

10,376

10,660

11,195

11,236

12,908

12,978

13,068

Percent of short-term debt (by residual maturity)

106

67

75

66

72

88

89

107

104

Months of following year's imports of goods and nonfactor services

4.7

6.1

7.0

6.8

7.2

7.4

8.4

8.1

7.6

Net international reserves

7,349

7,967

9,365

9,644

10,374

10,483

12,205

12,275

12,365

Reserves (Fixed, percent of RAM) 6/

89.5

72.2

81.3

79.1

82.8

86.4

98.3

100.0

100.8

External debt service to exports ratio (percent)

58.4

53.7

85.6

71.6

77.6

76.3

66.1

76.8

65.9

Total external debt (percent of GDP)

77.7

85.0

99.1

101.1

103.9

102.9

106.1

104.3

101.0

Net external debt (percent of GDP)

40.6

51.4

62.7

66.1

66.5

65.6

68.7

67.0

63.6

Exchange rate

Kuna per euro, end of period 8/

7.3

7.4

7.3

7.4

7.5

7.6

7.6

7.6

…

Kuna per euro, period average 8/

7.3

7.2

7.3

7.3

7.4

7.5

7.6

7.7

…

Real effective rate (CPI, percent change) 4/ 9/

0.7

4.6

1.2

-2.6

-2.1

-1.9

2.5

1.9

...

Memorandum items:

Nominal GDP (millions of euros)

43,380

47,537

44,770

44,428

44,195

43,686

43,645

43,518

44,203

Output gap (percent of potential)

3.2

4.2

-2.2

-2.6

-1.6

-2.8

-2.3

-2.2

-2.1

Per capita GDP (2012, WEO): $12,829

Percent of population below poverty line (2004): 11.1
Percent of population below poverty line (2004): 11.1
Percent of population below poverty line (2004): 11.1

Quota (2010): SDR 365 million (563 million U.S. dollars)

Sources: Croatian authorities; and IMF staff estimates.

1/ Under the new ESA95 methodology, revised data include estimates for the "gray economy," imputed dwelling rates, and financial intermediate services indirectly measured (FISIM). National account data for 1995-2008 were revised in 2009 and data for 2008-2011 were revised in 2012.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2 At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.